Thursday, 30 August 2012

There can be a rational debate about the costs and benefits
of immigration, and what that implies about immigration controls. And there can
be political debate, which is nearly always something different. I know this is
an issue
in the US, but I suspect we in the UK have probably more experience in how to
be really nasty to foreigners who want to come here.

Probably most UK academics have some experience of how the
UK authorities deal with student visas. A recent case I was involved with
concerned a student who had their visa refused because of a mistake that the immigration
officials acknowledged was their own. However they would only overturn the
decision if the student went through an expensive appeals process, or reapplied
through a solicitor, which was still expensive but less so. They did the
latter, successfully and with university support, but the whole process took
time and caused considerable distress. Not only did the bureaucracy make a
mistake, it also made the innocent party pay for the bureaucracy’s mistake.

The latest example is the UK Border Agency’s decision to revoke the
right of the London Metropolitan University to sponsor students from outside
the EU. The Agency has problems with the university’s monitoring of these
students. Whether or not the Agency has a case against the university,
the decision means
that over 2,500 students, many of whom are midway through their course, have 60
days to find an alternative institution to sponsor them or face deportation.
The Agency has no reason to believe, and has not claimed, that the majority of
them are not perfectly genuine students
who have paid good money to study in the UK. The Agency does not have to punish
innocent students to punish the university. I guess it might call them collateral
damage, but in this case the damage seems easily avoidable.

The government has apparently set up a ‘task force’ to help
these students. Its work will not be easy,
but it is certainly not going to make the emotional distress these students are
currently suffering go away. What it does illustrate is that this decision is
no unhappy accident due to an overzealous arm of government. It looks like a
deliberate government attempt to show that it is being ‘tough on immigration’.

Aside from the human cost, there is the economic damage this
does to an important UK export industry. There are around 300,000 overseas
students in the UK. Universities UK estimates
that these students contribute £5 billion a year (0.3% of GDP) in fees and off-campus
expenditure. Unlike the rest of the UK economy, this is an export industry that
has been growing rapidly, but in a highly competitive market. Changes to visa regulations
already announced has led to study visas issued in the year to June 2012 falling
sharply compared with the previous 12 months. It is pretty obvious what
impact the most recent decision involving London Met will have on prospective
students trying to decide whether to come to the UK or go elsewhere.

Student visas are not the only area involving immigration where
rational argument and sensible cost benefit analysis (of the economic or more
general kind) goes out of the window when political decisions are made.
Jonathan Portes notes
renewed pressure from parts of government to further deregulate the UK labour
market. While this seems a little strange for a labour market which is much
less regulated than most in Europe, it ignores the huge increase in regulation
the government has created as a result of tightening immigration rules. He says
"The extra employment regulation that the Government has imposed on
employers wishing to employ migrant workers—the cap on skilled migration—will,
using the Government's own methodology, reduce UK output by between £2 and 4
billion by the end of the Parliament."

Numbers like this are important, and it makes you wonder how
serious the government is about doing everything it can to get the economy
moving again. But what really makes me angry is the human misery this kind of
decision causes. Having seen one case at first hand, I can imagine what 2,500 others
are currently going through. But of course they do not have a vote, and it
would seem that in the eyes of the Minister responsible, Damian Green,
the votes he thinks he has gained by this decision are worth this collateral
damage.

Should all macroeconomic models in good journals include
their microfoundations? In terms of current practice the answer is almost
certainly yes, but is that a good thing? In earlier posts I’ve tried to suggest
why there might be a case for sometimes starting with an aggregate macro model,
and discussing the microfoundations of particular relationships (or lack of) by
reference to other papers. This is a pretty controversial suggestion, which
will appear for many to be a move backwards not just in time but in terms of
progress. As a result I started
with what I thought would be one fairly uncontroversial (but not exactly
essential) reason for doing this. However let me list here what I think are the
more compelling reasons for this proposal.

1) Empirical evidence. There may be strong empirical
evidence in favour of an aggregate relationship which has as yet no clear
microfoundation. A microfoundation may emerge in time, but policy makers do not
have time to wait for this to happen. (It may take decades, as in the microfoundations
for price rigidity.) Academics may have useful things to say to policy makers
about the implications of this, as yet not microfounded, aggregate
relationship. A particularly clear case is where you model what you can see rather than what you can microfound. For further discussion see this post.

2) Complexity. In a recent post
I discussed how complexity driven by uncertainty may make it impossible to
analytically derive microfounded relationships, and the possible responses to
this. Two of the responses I discussed stayed within microfoundations
methodology, but both had unattractive features. A much more tractable
alternative may be to work directly with aggregate relationships that appear to
capture some of this complexity. (The inspiration
for this post was Carroll’s paper that suggested Friedman’s PIH did just that.)

3) Heterogeneity. At first sight heterogeneity that matters
should spur the analysis of heterogeneous agent models of the kind analysed here, which
remain squarely within the microfoundations framework. Indeed it should.
However in some cases this work could provide a rationalisation for aggregate
models that appear robust to this heterogeneity, and which are more tractable.
Alan Blinder famously found that
there was no single front runner for causes of price rigidity. If this is
because an individual firm is subject to all these influences at once, then
this is an example of complexity. However if different types of firm have
different dominant motives, then this is an example of heterogeneity. Yet a
large number of microfoundations for price rigidity appear to result in an
aggregate equation that looks like a Phillips curve. (For a recent example, see
Gertler and Leahy here.)
This might be one case where working with aggregate relationships that appear
to come from a number of different microfoundations gives you greater
generality, as I argued here.

4) Aggregate behaviour might not be reducible to the
summation of individuals optimising. This argument has a long tradition,
associated with Alan
Kirman and others.
I personally have not been that persuaded by these arguments because I’ve not
seen clear examples where it matters for bread and butter macro, but that may
be my short-sightedness.

5) Going beyond simple microeconomics. The microeconomics
used to microfound macromodels is normally pretty simple. But what if the real
world involves a much more substantial departure from these simple models?
Attitudes to saving, for example, may be governed by social norms that are not
always mimicked by our simple models, but which may be fairly invariant over
some macro timescales, as Akerlof has suggested.
This behaviour may be better captured by aggregate approximations (that can at
least be matched to the data) than a simple microfoundation. We could include
under this umbrella radical departures from simple microfoundations associated
with heterodox economists. I do not think the current divide
between mainstream and heterodox macro is healthy for either side.

If this all seems very reasonable to you, then you are probably not writing research papers in
the macroeconomics mainstream. Someone who is could argue that once you lose
the discipline of microfoundations, then anything goes. My response is that
empirical evidence should, at least in principle, be able to provide an
alternative discipline. In my earlier post
I suggested that the current hegemony of microfoundations owed as much to a
loss of faith in structural time series econometrics as it did to the
theoretical shortcomings of non-microfounded analysis. However difficulties
involved in doing time series econometrics should not mean that we give up on
looking at how individual equations fit. In addition, there is no reason why we
cannot compare the overall fit of aggregate models to microfounded
alternatives.

While this post lists all the reasons why sometimes starting
with aggregate models would be a good idea, I find it much more difficult to
see how what I suggest might come about. Views among economists outside macro,
and policy makers, about the DSGE approach can be pretty disparaging, yet it is
unclear how this will have any influence on publications in top journals. The
major concern amongst all but the most senior (in terms of status) academic
macroeconomists is to get top publications, which means departing from the DSGE
paradigm is much too risky. Leaders in the field have other outlets when they
want to publish papers without microfoundations (e.g. Michael Woodford here).

Now if sticking with microfoundations meant that
macroeconomics as a whole gradually lost relevance, then you could see why the
current situation would become unsustainable. Some believe the recent crisis
was just such an event. While I agree that insistence on microfoundations discouraged
research that might have been helpful during and after the crisis, there is now
plenty of DSGE analysis of various financial frictions (e.g. Gertler and
Kiyotaki here)
that will take the discipline forward. I think microfoundations macro deserves
to be one of, if not the, major way macro is done. I just do not think it is
the only route to macroeconomic wisdom, but the discipline at the moment acts
as if it is.

Saturday, 25 August 2012

Some of the regular blogs I read are currently preoccupied
(understandably) with the US Presidential election. This is not my territory,
but the role of fiscal
councils – in this case the CBO – in
costing budget proposals is, and the two connect with the analysis of the Ryan
budget plan.
The Ryan ‘plan’ involves
cutting the US budget deficit, but contains hardly any specifics about how that
will be done.

There is nothing unique to the US here. In the 2010 UK
elections, both main parties acknowledged the need for substantial reductions
in the budget deficit over time, but neither party fully specified how these
would be achieved. Now as the appropriate speed of deficit reduction was a key
election issue, this might seem surprising. In particular, why did one party
not fully specify its deficit reduction programme, and then gain votes by
suggesting the other was not serious about the issue?

The answer has to be that any gains in making the plans
credible would be outweighed by the political costs of upsetting all those who
would lose out on specific measures. People can sign up to lower deficits, as
long as achieving them does not involve increasing their taxes or reducing
their benefits. However, I think it’s more than this. If people were fully
aware of the implications of what deficit reduction plans might entail, you would
guess that lack of information might be even more damaging than full
information. As people tend to be risk averse, the (more widespread) fear that their
benefits might be cut could be more costly in electoral terms than a smaller
number knowing the truth.

The fact that this logic does not operate suggests to me
that (at least among swing voters) there is a bigger disconnect in people’s
minds between aggregate deficit plans and specific measures. Saying you will be
tough on the deficit does not panic swing voters, but adds to your credibility
in being serious about the deficit ‘problem’. Indeed, from my memory of the UK
election, claims by one side about secret plans of the other were effectively
neutralised as scaremongering.

This can be seen as the reverse side of a familiar cause of deficit
bias. A political party can gain votes by promising things to specific
sections of the electorate, but does not lose as many votes because of worries
about how this will be paid for. The media can correct this bias by insisting
on asking where the money will come from (or in the reverse case, where the
cuts will come from), but they may have limited ability to check or interrogate
the answer. This is where a fiscal
council, which has authority as a result of being set by government but also
independent of government, can be useful.

For some time the Netherlands
Bureau for Economic Policy Analysis (often called the CPB) has offered to
cost political parties fiscal proposals before elections. The interesting
result is that all the major parties take up this offer. Not having your fiscal
plans independently assessed appears to be a net political cost.

What the fiscal council is doing in this case is conferring
an element of legitimacy on aggregate fiscal plans, a legitimacy that is more
valuable than uncosted fiscal sweeteners. Which brings me to the question of
what a fiscal council should do if these plans are clearly incomplete? In
particular, suppose plans include some specific proposals that are deficit
increasing or neutral, but unspecified plans to raise taxes or cut spending
which lead to the deficit being reduced. By ‘should do’ here I do not mean what
it is legally obliged to do, but what would be the right thing to do.

It seems to me clear that the right thing to do is not to cost the overall budget. What,
after all, is being achieved by doing so? Many people or organisations can put
a set of numbers for aggregate spending and taxes into a spreadsheet and
calculate implied deficits, and the adding up can easily be checked. By getting
the fiscal council to do this fairly trivial task serves no other purpose than
to give the plan a legitimacy that it does not have.

In this situation, a fiscal council that does
calculate deficit numbers for a plan that leaves out all the specifics is
actually doing some harm. Instead of asking the difficult questions, it is
giving others cover to avoid answering them. It is no excuse to say that what
was done is clear in the text of the report. The fiscal council is there partly
so people do not have to read the report. So I wonder if the CBO had any
discretion in this respect. If Ryan was playing
the system, perhaps the system needs changing to give the CBO a little more
independence.

Friday, 24 August 2012

I have written a bit about multipliers, particularly of the
balanced budget kind, but judging by comments some recap and elaboration may be
useful. So here is why, for all government spending multipliers, one is the
number to start from. To make it a bit of a challenge (for me), I’ll not use any
algebra.

Any discussion has to be context specific. Imagine a two
period world. The first period is demand deficient because interest rates are
stuck at the zero lower bound[1],
but in the (longer) second period monetary policy ensures output is fixed at
some level independent of aggregate demand (i.e. its supply determined). Government
spending increases in period 1 only. That is the context when these multipliers
are likely to be important as a policy tool.

1) Balanced budget multiplier

To recap,
for a balanced budget multiplier (BBM), here is a simple proof in terms of
sector balances for a closed economy. A BBM by definition does not change the
public sector’s finance balance (FB). It seems very reasonable to assume that consumers
consume a proportion less than one of any change to their first period post-tax
income. So if higher taxes reduced income, their consumption falls by less, so
their FB moves into deficit. But as the sum of the public and private sector’s
FB sums to zero, it cannot do this. So post-tax income cannot fall. Hence
pre-tax income must rise to just offset the impact of higher taxes. The BBM is
one.

The nice thing about this result is that it holds whatever
fraction of current income is consumed (as long as it’s less than one), so it
is independent of the degree of consumption smoothing. What about lower
consumption in the second period? No need to worry, as monetary policy ensures
demand is adequate in the second period.

Although a good place to start, allowing for an impact on
expected inflation and therefore real interest rates will raise this number
above one. In addition, as DeLong
and Summers discuss, hysteresis effects will also raise period 2 output and
income from the supply side, some of which consumers will consume in period 1.
We would get similar effects if the higher government spending was in the form
of useful intrastructure investment. So in this case one is the place to start,
but it looks like a lower bound.

2) BBM in an open economy

I’m still seeing people claim that the BBM in an open
economy is small. It could be, if the government acts foolishly. Suppose the
government increases its spending entirely on defence, which in turn consists
of buying a new fighter jet from an overseas country. The impact on the demand
for domestic output is zero. But consumers are paying for this through higher
taxes, so their spending decreases – we get a negative multiplier.

Now consider the opposite: the additional government
spending involves no imported goods whatsoever. The multiplier is one. You can
do the maths, but it is easy to show that this is a solution by thinking about
the BBM in a closed economy. There consumption does not change, because a BBM=1
raises pre-tax income to offset higher taxes. But if consumption does not
change, neither will imports, so this is also the solution in the open economy
case.

What the textbooks do is apply a marginal propensity to
import to total output, which implicitly assumes that the same proportion of
government spending is imported as consumption spending. For most economies
that is not the case, as the ‘home bias’ for government spending is much
larger. Furthermore, if the government is increasing its spending with the aim
of raising output, it can choose to spend it on domestically produced output
rather than imports. So, a multiplier of one is again a good place to start.
Allowing some import leakage will reduce the multiplier, but this could easily
be offset by the real interest rate effects discussed above, particular as
these would in an open economy depreciate the real exchange rate.

3) Debt financed government spending with future tax
increases

Although this is the standard case, from a pedagogical point
of view I think it’s better to start with the BBM, and note that it’s all the
same with Ricardian Equivalence. We can then have a discussion about which are
the quantitatively important reasons why Ricardian Equivalence does not hold.
All these go to raise the multiplier above one. You have to add, however, some
discussion about the impact that distortionary tax increases will have on
output in the second period, which reduces second period output and, through consumption
smoothing, the size of the first period multiplier.

4) Debt financed government spending without tax increases

In an earlier post
I queried why arguments for the expansionary impact of government spending
increases always involved raising taxes at some point. For debt finance, why
not assume lower government spending in the future rather than higher taxes.
The advantage is that you do not need to worry about supply side tax effects. Monetary
policy ensures there is no impact on output of lower government spending in the
second period. Now, unlike the BBM case, we do need to make some assumptions
about the degree of consumption smoothing. If you think the first period is
short enough, and consumers smooth enough, such that the impact of higher
income on consumption in the first period is negligible, then we have a
multiplier of one again.

[1]I
assume Quantitative Easing cannot negate the ZLB problem, and that inflation
targets are in place and fixed. This is not about fiscal stimulus versus NGDP
targeting, but just about macro theory.

Thursday, 23 August 2012

The editors of the EUROPP blog, run by the Public Policy
Group at the London School of Economics, wanted to contrast Hayekian and
Keynesian views of the Eurozone crisis, by running posts from either side. Here
is the Hayekian view, from Steven Horwitz, and for better or worse I provide
the Keynesian view here. To be honest it is my view of the Eurozone crisis,
which I think owes a lot to Keynesian ideas – it is absolutely not an attempt
to guess what Keynes would have said if he could speak from the grave.

While regular readers of my blog will not find anything very
new here, I personally found it useful to put my various posts into a
brief but coherent whole. What struck me when I did so was the gulf between my
own perspective (which is not particularly original, and borrows a great deal
from the work of others like Paul De Grauwe),
and that of most Eurozone policymakers. It is a gulf that goes
right back to when the Euro was formed.

Much of the academic work before 2000 looking at the
prospects for the Euro focused on asymmetric or country specific shocks, or
asymmetric adjustment to common shocks due to structural differences between countries.
My own small contribution,
and those of many others, looked at the positive role that fiscal policy could play in
mitigating this problem. Yet most European policymakers did not want to hear
about this. Instead they were focused on the potential that a common currency
had for encouraging fiscal profligacy, because market discipline would be reduced.

Now this was a legitimate concern – as some Greek politicians
subsequently showed. However what I could not understand back then, and still cannot today, is how this concern can justify ignoring the problem of asymmetric shocks. I can still
remember my surprise and incomprehension when first reading the terms of the
Pact – what were Eurozone policymakers thinking? My incredulity has certainly
been validated by events, as the Eurozone was hit by a huge asymmetric shock as
capital flowed into periphery countries and excess demand there remained
unchecked. Now countercyclical fiscal policy in those countries would not have
eliminated the impact of that shock, at least not according to my own work, but it would have
significantly reduced its impact.

When I make this point, many respond that fiscal policy in
Ireland or Spain was probably contractionary during this time – am I really suggesting it
should have been tighter still? Absolutely I am, and the fact that this
question is so often asked partly reflects the complete absence of discussion
of countercyclical fiscal policy by Eurozone policymakers. Brussels was too
busy fretting about breaches of the SGP deficit limits, and largely ignoring
the growing competitiveness divide between Germany and most of the rest. (Maybe this is a little unfair on the Commission. I have been told that when the Commission did raise
concerns of this kind, they were dismissed by their political masters.)

If periphery countries had pursued aggressive
countercyclical fiscal policies before 2007, would the Eurozone crisis have started
and ended with Greece? Who knows, but it certainly would have been less of a
crisis than the one we have now.

This is just one aspect of the policy failure that is the Eurozone
crisis. Another is the fiction of expansionary austerity, and yet another is
the obsession by the ECB with moral hazard (or even worse
their balance sheet). As I say at the end of my EUROPP post, there is a pattern
to all these mistakes. It reflects a world view that governments are always the
problem, and private sector behaviour within competitive markets never requires
any intervention. Whether you attribute that view to Hayek, or Ordoliberalism, or
something else is an interesting academic question. But what the Eurozone
crisis shows all too clearly is the damage that this world view can do when it
becomes the cornerstone of macroeconomic policy.

Monday, 20 August 2012

Below is a chart of UK net debt to GDP from the mid 1970s
until the onset of the Great Depression. This post is about the right hand third
of this chart, from 1998 to 2007, which was the period during which Gordon
Brown was Chancellor.

UK Net
Debt as a Percentage of GDP (financial years) – Source OBR

In general looking at figures for debt can give you a rather
misleading impression of what fiscal policy is doing, particularly over short
intervals. However, having finished trawling through budget reports and other
data for a paper I am writing, I can safely say that this chart tells a pretty
accurate story. (For those who cannot wait for the detail that will be in my
paper, there is an excellent account by Alan Budd here.) In the
first two years of his Chancellorship, Brown continued his predecessor’s policy
of tightening fiscal policy. The budget moved into small surplus, so that the
debt to GDP ratio fell to near 30% of GDP. Policy then shifted in the opposite
direction, with a peak deficit of over 3% of GDP, a period which included
substantial additional funding to the NHS. The remaining five budgets were
either broadly neutral or mildly contractionary in the way they moved policy,
but as this was starting from a significant deficit, the net result was a
continuing (if moderating) rise in debt.

Why was fiscal policy insufficiently tight over most of this
period? Despite what Gordon Brown said at the end of his term, I do not think
this had anything to do with the business cycle. In one sense there is nothing
unusual to explain: we are used to politicians being reluctant to raise taxes
by enough to cover their spending, which leads to just this kind of deficit
bias. However this should not have happened this time because policy was
being constrained by two fiscal rules designed to prevent this. So what went
wrong with the rules?

The first answer is in one sense rather mundane. The rules,
as all sensible fiscal rules should, tried to correct for the economic cycle.
However, rather than use cyclically adjusted deficit figures, Gordon Brown’s
rules looked at average deficits over the course of an economic cycle. That
allowed Brown to trade off excessively tight policy in the early years against
too loose policy towards the end, and still (just) meet his rule. As we can
roughly see from the chart, debt ends up about where it started under his
stewardship, which also roughly coincided with a full cycle.

Was this intended? The answer is to some extent not, which
brings us to the second reason policy was too loose, and that is forecast
error. One of the striking things about reading through the budget reports is
how persistent these errors were. Outturns seemed always more favourable than
expected over the first part of this period, until they became persistently
unfavourable in the second. The former encouraged forecasters to believe higher
than expected tax receipts represented a structural shift, and they were
reluctant to give up that view in the second period. Unlucky or an aspect of
wishful thinking that is often part
of deficit bias?

To their credit, the current Conservative led government
learnt from both these mistakes. Most notably, they set
up the independent Office for Budget Responsibility with the task of
producing forecasts without any wishful thinking. In addition their fiscal
mandate is also defined in terms of a cyclically adjusted deficit figure, which
does not have the backward looking bias inherent in averaging over the past
cycle. Their mistake
is in trying to meet that mandate when the recovery had only just begun.

What this chart does not show are the actions of a
spendthrift Chancellor who left the economy in a dire state just before the
Great Recession. He stopped being Chancellor with debt roughly where it was
when he started, and a deficit only moderately above the level required to keep
it there. The spin
that our current woes are the result of the awful mess Gordon Brown left the UK
economy in is a distortion based on a half-truth. The half truth is that it
would have been better if fiscal policy had been tighter, leaving debt at 30%
rather than 37% when the recession hit. The distortion is that the high deficit and
debt when labour left office in 2010 were a consequence of the recession, and
commendable attempts to limit its impact on output and employment.

Saturday, 18 August 2012

For those interested
in microfoundations macro. Unlike earlier posts, I make no judgement about the
validity or otherwise of the microfoundations approach, but instead just try
and clarify two different motivations behind microfoundations.

When I discuss the microfoundations project, I say that
internal consistency is the admissibility criteria for microfounded models. I
am not alone in stressing the role of internal consistency: for example in the preface
to their highly acclaimed macroeconomics textbook, Obstfeld and Rogoff (1996) argue
that a key problem with the pre microfoundations literature is that it “lacks
the microfoundations needed for internal consistency”. However when others talk
about microfoundations, they often say they are designed to avoid the Lucas critique.
This post argues that the latter is just a particular case of the former.

What do we mean when we say a model is internally
consistent? Most obviously, we mean that individual agents within the model
behave consistently in making their own decisions. A trivial example is if the
model contains a labour supply equation and a consumption function that are
supposed to represent the behaviour of the same agent. In that case we would
want the agent to behave consistently. An agent that became more impatient, and
so wanted to consume more by borrowing, but also wanted to work more hours (and
so exhibit less impatience in their consumption of leisure), would appear to
behave inconsistently unless their preferences or prices also
changed.

Suppose instead of a labour supply equation, we had wage
setting by unions. In this case we have a consistency issue between two sets of
agents: consumers and unions. If we wanted to model unions as representing
consumers as workers, we would want to align their preferences, so we are back
to the previous case. However, there may be reasons why we do not want to do
this. If we did not, we would want to make sure these agents interrelated in a
sensible way.

What is meant by a sensible way? Consumer’s decisions will
almost certainly depend on expectations about the wages unions set. Lucas
called rational expectations a ‘consistency axiom’. If, for example, the union
started being more concerned about employment than wages, we might expect
consumers to recognise this in thinking about how their future income might
evolve.

The Lucas critique is just an example of consistency between
agents. The question is whether the private sector agents in the model react in
a sensible way to policy changes. The classical example of the Lucas critique
is inflation expectations. If monetary policy changes to become much harder on
inflation, then rational agents will incorporate that into the way they form
inflation expectations. A model that did not have that feedback would be
‘subject to the Lucas critique’.

Discussion of the Lucas critique often involves the need to
model in terms of ‘deep’ parameters. A deep parameter (like impatience) is one
that is independent of (exogenous to) the rest of the model. Here the
parameters of the rule agents’ use to forecast inflation are not deep parameters,
because (under rational expectations) they depend on how policy is made. But we
can have a similar discussion about workers and unions: if the latter aimed at
representing the former, then union attitudes to the wage/employment trade off
should not be independent of worker preferences. Internal consistency is again
more general than the Lucas critique.

Now obviously the Lucas critique is a particularly important
kind of inconsistency if you are interested in analysing policy. But it is not
the only kind of inconsistency that matters. A very good example of this is
Woodford’s derivation of a social welfare function from the utility function of
agents. Before this work, macroeconomists had typically assumed that a
benevolent policy maker would minimise some quadratic combination of excess
inflation and output, but this was disconnected from consumers’ utility. This
had no bearing on the Lucas critique, which applies to any policy, benevolent
or not. However it was a glaring example of inconsistency – why wasn’t the
policy maker maximising the representative agent’s utility? After Woodford’s
analysis, nearly every macroeconomics paper followed his example: not because
it did anything about the Lucas critique, but because it solved an internal
consistency issue.

Why does putting the Lucas critique in its proper place
matter? I can think of two reasons. First, if you believe that avoiding the
Lucas critique means you necessarily have a microfounded model, you are wrong. (In
contrast, an internally consistent model will avoid the Lucas critique.)
Second, it has a bearing on the idea often put forward that microfounded models
are just for policy analysis, but not for forecasting. If we think that
microfoundations is all about the Lucas critique, then this mistake is
understandable (although still a mistake). But if microfoundations is about internal
consistency, then it is easier to see how a microfounded model could be much better at forecasting as
well as policy analysis.

Thursday, 16 August 2012

In February 2010, 20 economists including a number of
academics of note signed a letter
that endorsed the Conservative Party’s deficit reduction plan for the UK. Although
20 is a small number (I’m sure many more – like me – were asked to sign and did
not), they made up in quality what they lacked in quantity. The New Statesman magazine
recently had the bright idea of asking them “whether they regretted signing the
letter and what they would do to stimulate growth”. It published the results
yesterday.

Half of the signatories replied. The headline was that most
have changed their mind. Actually the responses are more varied, but interesting
given that they are mostly well known academics. For example Ken Rogoff simply says
“I have always favoured investment in high-return infrastructure projects that
significantly raise long-term growth” which you can interpret how you want. A
few are brave enough to say they have changed their minds. Only Albert Marcet says
that he has no regrets.

400 economists have signed up
in favour of Romney for President. Of course we all know that everything is
always done bigger and louder in the US, but I think Andrew Watt is right when
he says that it is “unusual in Europe, at least in the countries I know, for
academic economists to ally themselves party-politically in such a clear fashion”.
I only know the UK well enough to judge, but in that case I think he is right,
and the New Statesman responses illustrate this. They do not represent the
comments of those who would support a party or ideological position come what
may. The 42 French economists who wrote
a letter endorsing Hollande’s recovery plan seem more in the UK tradition of
supporting particular policies in their own words. In contrast the 400 seem to
be signing up to something that could only have been written by a political
machine.

So if there is a difference between the US and at least some
parts of Europe here, why is this? Andrew Watt wonders whether the more fluid
nature of the civil service in the US has something to do with it. While that
might explain the actions of those with a real chance of a top job, can it
really explain what appears to be a much more widespread difference? Perhaps European
economists just attach greater value to masking their political or ideological
prejudices, but in a way that just moves the question sideways – why do they
attach more value to this?

Yet perhaps I’m asking the wrong question here. Is the issue
about US/European differences, or is it about what drives those who support the
Republican Party in the US? The fact that parts of the Republican Party appear
quite anti-science (evolution is just one theory), as well as anti-economics (tax cuts reduce the deficit), would surely have the effect of putting academics
off publicly associating themselves with that party. I can see why that would
make a Republican candidate particularly keen to be seen to have academic
support, but not why so many seem happy to give their blanket support.

When I get asked to sign letters, there is always an
internal debate between part of me that agrees with the cause and another that
does not agree with everything that is written in the letter supporting that
cause. Sometimes one side wins and I sign, and sometimes the other side wins
and I don’t. Applying the same logic to the 400, the cause must be really
important. Either the prospect of a Romney victory must be so appealing, or the
threat of another Obama Presidency so awful, that those signing have been willing
to put all their normal critical faculties and sensibilities to one side. Or to go further, and write
supporting documents in a way that either ignores what the evidence suggests or
tries to suggest the evidence says what it does not, something that neither
scientists nor engineers would do.

In a world still suffering greatly from the consequences of
ineffective financial regulation, is the threat of marginally more effective
regulation that dire? In an economy where tax rates on the rich have fallen and
inequality has increased massively (whatever John Cochrane may want
to believe), is the prospect of that not continuing so appalling? Is the
prospect of just a bit less rather than a lot less government so terrifying that
you are happy to sign up to obvious distortions like “Obama has offered no plan
to reduce federal spending and stop the growth of the debt-to-GDP ratio”?
It is this I find hard to understand.

Martin Wolf comments
that it would be naive to think that economics could ever be as free from
ideological or political influence as science or engineering, and I agree.
However that does not mean that it is wrong to try and expose and reduce that
influence. So it is therefore interesting if the influence of right wing
politics and free market ideology is less powerful in some parts of Europe than
it is in the US. Unfortunately I have little idea quite why that is and what it
implies.

Wednesday, 15 August 2012

A simplistic view of the link between house prices and
consumption is that lower house prices reduce consumers’ wealth, and wealth
determines consumption, so consumption falls. But think about a closed economy,
where the physical housing stock is fixed. Housing does not provide a financial
return. So if house prices fall, but aggregate labour income is unchanged, then
if aggregate consumption falls permanently
the personal sector will start running a perpetual surplus. This does not make
sense.

The mistake is that although an individual can ‘cash in’ the
benefits of higher house prices by downgrading their house, if the housing
stock is fixed that individual’s gain is a loss for the person buying their
house. Higher house prices are great for the old, and bad for the young, but
there is no aggregate wealth effect.

As a result, a good deal of current analysis looks at the
impact house prices may have on collateral, and therefore on house owners
ability to borrow. Higher house prices in effect reduce a liquidity or credit constraint.
Agents who are credit constrained borrow and spend more when they become less
constrained. There is no matching reduction in consumption elsewhere, so
aggregate consumption rises. If it turns out that this was a house price
bubble, the process goes into reverse, and we have a balance sheet recession[1].
In this story, it is variations in the supply of credit caused by house prices
that are the driving force behind consumption changes. Let’s call this a credit effect.

There is clear US evidence
that house price movements were related to changes in borrowing and
consumption. That would also be consistent with a wealth effect as well as a
credit constraint story, but as we have noted, in aggregate the wealth effect
should wash out.

Or should it? Let’s
go back to thinking about winners and losers. Suppose you are an elderly
individual, who is about to go into some form of residential home. You have no
interest in the financial position of your children, and the feeling is mutual.
You intend to finance the residential home fees and additional consumption in
your final years from the proceeds of selling your house. If house prices
unexpectedly fall, you have less to consume, so the impact of lower house
prices on your consumption will be both large and fairly immediate. Now think
about the person the house is going to be sold to. They will be younger, and
clearly better off as a result of having to fork out much less for the house.
If they are the archetypal (albeit non-altruistic) intertemporal consumer, they
will smooth their additional wealth over the rest of their life, which is
longer than the house seller. So their consumption rises by less than the house
seller’s consumption falls, which means aggregate consumption declines for some
time. This is a pure distributional
effect, generated by life-cycle differences in consumption.

In aggregate, following a fall in house prices, the personal
sector initially moves into surplus (as the elderly consume less), and then it
moves into deficit (as the elderly disappear and the young continue to spend their
capital gains). In the very long run we go back to balance. This reasoning assumes
that the house buyer is able to adjust to any capital gains/losses over their
entire life. But house buyers tend to be borrowers, and are therefore more
likely to be credit constrained. So credit effects could reverse the sign of distributional effects.

This is a clear case where micro to macro modelling, of the
kind surveyed in the paper by
Heathcote, Storesletten and Violante, is useful in understanding what might
happen. An example related to UK experience is a paper
by Attanasio, Leicester and Wakefield (earlier pdf here).
This tries to capture a great deal of disaggregation, and allows for credit
constraints, limited (compared to the Barro ideal) bequests and much more, in a
partial equilibrium setting where house price and income processes are
exogenous. The analysis is only as good as its parts, of course, and I do not
think it allows for the kind of irrationality discussed here. In addition, as housing markets differ significantly between
countries, some of their findings could be country specific.

Perhaps the most important result of their analysis is that
house prices are potentially very important in determining aggregate
consumption. According to the model, most movements in UK consumption since the
mid-1980s are caused by house price shocks rather than income shocks. In terms
of the particular mechanism outlined above, their model suggests that the impact of house prices on the old dominate
those on the young, despite credit constraints influencing the latter more. In
other words the distributional effect of lower
house prices on consumption is negative. Add in a collateral credit effect, and the model predicts lower house prices will significantly reduce aggregate consumption, which is the aggregate correlation we tend to observe.

But there remains an important puzzle which the paper discusses
but does not resolve. In the data, in contrast to the model, consumption of the
young is more responsive to house price changes than consumption of the old. The
old appear not to adjust their consumption following house price changes as
much as theory suggests they should, even when theory allows a partial bequest motive. So there remain important unresolved issues about how house prices influence consumption in the real world.

[1]This
is like the mechanism in the Eggertsson and Krugman paper,
although that paper is agnostic about why borrowing limits fall. They could
fall as a result of greater risk aversion by banks, for example.

Monday, 13 August 2012

To get a variety of
views on this issue, read this post from Bruegel . Here is my view.

We can think of the governments of Ireland or Spain facing a
multiple equilibria problem when trying to sell their debt. There is a good
equilibrium, where interest rates on this debt are low and fiscal policy is sustainable. There is a
bad equilibrium, where interest rates are high, and because of this default is
possible at some stage. Because default is possible, a high interest rate makes
sense – hence the term equilibrium.

Countries with their own central bank and sustainable fiscal
policy can avoid the bad equilibria, because the central bank would buy
sufficient government debt to move from the bad to the good. (See this pdf by Paul De Grauwe.) The threat that
they would do this means they may not need to buy anything. Anyone who
speculates that interest rates will rise will lose money, so the interest rate
immediately drops to the low equilibrium.

How do markets know the central bank will do this, if that
central bank is independent? They might reason that independence would be taken
away by the government if the central bank refused. But suppose independence
was somehow guaranteed. Well, they might look at what the central bank is
doing. If it is already buying government debt as part of a Quantitative Easing
(QE) programme, then as long as the same conditions remain the high interest
outcome would
not be an equilibrium.

Suppose instead that the central bank does not have a QE
programme, and announces that it will only undertake one if the country
concerned agrees to sell some of its debt to other countries under certain
onerous conditions, and agreement is uncertain. We are of course talking about
the ECB. Now the bad equilibrium becomes a possibility again. Perhaps the
country will not agree to these onerous conditions. As Kevin O’Rourke points
out, this possibility is quite conceivable for a country like Italy. Equally,
based on past experience, the lenders may only agree if there is partial
default. Neither of these things needs to be inevitable, just moderately
possible – after all, interest rates are high only because there is a non-negligible
chance of default. The ECB also says that even if the country and its potential
creditors agree, it may still choose not to buy that country’s bonds. This
throws another lifeline to the existence of a bad equilibrium.

So, we have moved from a situation where the bad equilibrium
does not exist, to one where it can. As the good equilibrium is clearly better
than the bad one, there must be some very good reason for the ECB to impose
this kind of conditionality. What could it be?

The ECB’s mandate is price stability. So without
conditionality, would there be an increased risk of inflation? One concern is
that printing more money to buy government debt will raise inflation. But that
does not appear to be a concern in the UK and US, for two very good reasons.
First, the economy is in recession, or experiencing a pretty weak recovery.
Second, central bank purchases of government debt are reversible,
if inflation did look like it was becoming a serious problem.

What about the danger that by buying bonds now, when there
is no inflation risk, governments will be encouraged to follow imprudent fiscal
policies at other times when inflation is an issue. But why would the ECB buy
government bonds in that situation? Buying bonds now does not commit the ECB to
do so in the future. No one thinks the Fed will be doing QE in a boom. OK, what
about all those ‘structural reforms’ that might not occur if the bad equilibria
disappeared? Well, quite simply, that is none of the ECB’s business. It has
nothing to do with price stability. If the ECB is worrying about structural
reforms, it is exceeding its mandate.

Cannot the same argument – that an issue is not germane to
price stability - be used about choosing between the good and bad equilibria?
No. The bad equilibrium, because it forces countries like Ireland and Spain to
undertake excessive
austerity (and because it may influence the provision of private sector credit
in those countries), is reducing output and will therefore eventually reduce inflation
below target. The only ‘conditionality’ the ECB needs to avoid moral hazard is
that intervention will take place only if the country in the bad equilibrium is
suffering an unnecessarily severe recession. The ECB can decide itself whether
this is the case by just looking at the data.

So, in my view, to embark on unconditional and selective
QE in the current situation is within the price stability
mandate of the ECB. To impose conditionality in the way it is doing is not
within its mandate. Unfortunately, as Carl Whelan points out,
this is not the first time the ECB has exceeded its mandate. As he also says,
if the Fed or Bank of England made QE conditional on their
governments undertaking certain ‘structural reforms’ or fiscal actions, there
would be outrage. So why do so many people write as if it acceptable for the
ECB to do this?

Saturday, 11 August 2012

In a previous post
I looked at a paper
by Carroll which suggested that the aggregate consumption function proposed by Friedman
looked rather better than more modern intertemporal consumption theory might
suggest, once you took the issue of precautionary saving seriously. The trouble
was that to show this you had to run computer simulations, because the problem
of income uncertainty was mathematically intractable. So how do you put the results
of this finding into a microfounded model?

While I want to use the consumption and income uncertainty
issue as an example of a more general problem, the example itself is very
important. For a start, income uncertainty can change, and we have some evidence
that its impact could be large. In addition, allowing for precautionary savings
could make it a lot easier to understand important issues, like the role of
liquidity constraints or balance sheet recessions.

I want to look at three responses to this kind of complexity, which I will call denial,
computation and tricks. Denial is straightforward, but it is hardly a solution.
I mention it only because I think that it is what often happens in practicewhen
similar issues of complexity arise. I have called
this elsewhere the streetlight problem, and suggested why it might have had
unfortunate consequences in advancing our understanding of consumption and the recent recession.

Computation involves embracing not only the implications of
the precautionary savings results, but also the methods used to obtain them as
well. Instead of using computer simulations to investigate a particular partial
equilibrium problem (how to optimally plan for income uncertainty), we put lots
of similar problems together and use the same techniques to investigate general
equilibrium macro issues, like optimal monetary policy.

This preserves the internal consistency of microfounded
analysis. For example, we could obtain the optimal consumption plan for the
consumer facing a particular parameterisation of income uncertainty. The
central bank would then do its thing, which might include altering that income
uncertainty. We then recompute the optimal consumption plan, and so on, until
we get to a consistent solution.

We already have plenty of papers where optimal policy is not
derived analytically but through simulation.(1) However these papers typically include microfounded equations for
the model of the economy (the consumption function etc). The extension I am talking about here, in its purest form, is where nothing is analytically derived. Instead the ingredients
are set out (objectives, constraints etc), and (aside from any technical
details about computation) the numerical results are presented – there are no
equations representing the behaviour of the aggregate economy.

I have no doubt that this approach represents a useful exercise, if robustness is investigated appropriately. Some of the very interesting comments to my earlier post did raise the question of
verification, but while that is certainly an issue, I do not see it as a critical problem. But could this ever become the main way we do macroeconomics? In
particular, if results from these kinds of black box exercises were not
understandable in terms of simpler models or basic intuition, would we be
prepared to accept them? I suspect they would be a complement to other forms of
modelling rather than a replacement, and I think Nick Rowe agrees, but I may be wrong. It would be
interesting to look at the experience in other fields, like Computable General
Equilibrium models in international trade for example.

The third way forward is to find a microfoundations 'trick'.
By this I mean a set up which can be solved analytically, but at the cost of
realism or generality. Recently Carroll has done just that for precautionary
saving, in a paper
with Patrick Toche. In that model a representative consumer works, has some
probability of becoming unemployed (the income uncertainty), and once
unemployed can never be employed again until they die. The authors suggest that
this set-up can capture a good deal of the behaviour that comes out of the
computer simulations that Carroll discussed in his earlier paper.

I think Calvo contracts are a similar kind of trick. No one
believes that firms plan on the basis that the probability of their prices
changing is immutable, just as everyone knows that one spell of unemployment
does not mean that you will never work again. In both cases they are a device
that allows you to capture a feature of the real world in a tractable way.

However, these tricks do come at a cost, which is how
certain we can be of their internal consistency. If we derive a labour supply
and consumption function from the same intertemporal optimisation problem, we
know these two equations are consistent with each other. We can mathematically
prove it. Furthermore, we are content that the underlying parameters of that
problem (impatience, the utility function) are independent of other parts of
the model, like monetary policy. Now Noah Smith is right
that this contentment is a judgement call, but it is a familiar call. With tricks like Calvo contracts, we cannot be that confident. This is something I hope to elaborate on in a subsequent post.

This is not to suggest that these tricks are not useful – I
have used Calvo contracts countless times. I think the model in Carroll and
Toche is neat. It is instead to suggest that the methodological ground on which
these models stand is rather shakier as a result of these tricks. We can never
write ‘I can prove the model is internally consistent’, but just ‘I have some reasons
for believing the model may be internally consistent’. Invariance to the Lucas critique becomes a much bigger judgement call.

There is another option that is implicit in Carroll’s original
paper, but perhaps not a microfoundations option. We use computer simulations of the kind he presents to justify an
aggregate consumption function of the kind Friedman suggested. Aggregate
equations would be microfounded in this sense (there need be no reference to
aggregate data), but they would not be formally (mathematically) derived. Now
the big disadvantage of this approach is that there is no procedure to ensure
the aggregate model is internally consistent. However, it might be much more
understandable than the computation approach (we could see and potentially
manipulate the equations of the aggregate model), and it could be much more
realistic than using some trick. I would like to add
it as a fourth possible justification for starting macro analysis with an
aggregate model, where aggregate equations were justified by references to papers
that simulated optimal consumer behaviour. (1) Simulation analysis can make use of mathematically derived first order conditions, so the distinction here is not black and white. There are probably two aspects to the distinction that are important for the point at hand, generality and transparency of analysis, with perhaps the latter being more important. My own thoughts on this are not as clear as I would like.

Thursday, 9 August 2012

Greg Mankiw is known to every economist and economics
student, if only because of his best selling textbook. John Taylor is known to
every macroeconomist, if only because of the large number of bits of macro with
his name on it (Taylor rule, Taylor contracts etc). Both are respected by other
academics because of the quality and influence of their academic work.

With two others, they recently wrote this
about the Obama administration’s attempts to stimulate the economy through
fiscal policy after the recession: “The negative effect of the administration’s ‘stimulus’ policies
has been documented in a number of empirical studies.” They then quote from two
studies. The first looks at a minor aspect of the stimulus packages, the Cash
for Clunkers attempt to bring forward car purchases. There are other studies
of this programme which are more favourable. The second study is co-authored by
John Taylor, and others
have interpreted his findings differently.

No other studies are directly referred to. That might just
be because the overwhelming majority suggest that the stimulus package worked. Dylan Matthews on Ezra Klein's blog documents them here.
As I wrote in a recent post, the evidence is about as clear as it ever is in
macro. Which is not too surprising, as it is what Mankiw’s textbook suggests,
and it is what the New Keynesian theory both authors have contributed to
suggests.

Now the quote comes from a paper prepared for the Romney
presidential campaign. It is clearly political in tone and intent. As both
academics are Republican supporters, it may therefore seem par for the course.
But it should not be. The Romney campaign publicised this paper because it was
written by academics – experts in their field. It allows those who oppose fiscal
stimulus to continue to claim that the evidence is on their side – look, these
distinguished academics say so.

It is one thing for economists to disagree about policy. It
would also be fine to say I know the evidence is mixed, but I think some evidence is more reliable. It is not fine to imply that the evidence points in
one direction when it points in the other. I say here imply, because the
authors do not explicitly say that the majority of studies suggest stimulus is
ineffective. If they chose their words carefully, then you have to ask whether ‘intending
to mislead’ is any better than ‘misrepresenting the facts’. Was that the intent,
or just an isolated unfortunate piece of bad phrasing? All I can say is read
the paper and judge for yourself, or this post
from Brad DeLong.

This is sad, because it tells us as much about economics as
an academic discipline as it does about the individuals concerned. In the past
I have imagined
something similar happening in physics. It actually stretches the imagination
to do so, but if it did, the academics concerned would immediately lose their
academic reputation. The credibility of their work would be questioned. Responding to evidence rather than ignoring it
is what distinguishes real science from pseudo science, and doctors from snake
oil salesmen.

What can economics as a discipline do about this sad state
of affairs? The answer is pretty obvious, to economists in particular, and that
is changing the incentives where we can. However we cannot do much about the
incentives provided by politics and the media. I have been pretty pessimistic
about this in the past,
but in a future post I will try and be more positive and talk about one
possible way forward.

Wednesday, 8 August 2012

From the Guardian's report
of Mervyn King’s press conference today, where the Bank of England lowers
forecast UK growth this year to zero.

Paul
Mason of Newsnight suggests that the Bank of England should stop trying to use
monetary policy to offset the impact of chancellor George Osborne's fiscal
tightening, and call for a Plan B instead.

King
rejects the idea, saying that Osborne's plan looked "pretty sensible"
back in 2010. Overseas factors have undermined it, he argues.

Now Mervyn King had little choice but to say this, but he is
wrong (and probably knows he is wrong) for a simple reason. Even if the post-2010
Budget forecast
of 2.8% growth in 2012 had been pretty sensible, there were risks either side.
There always are, although the nature of the recession probably made these
risks greater than normal. It is what you can do if those risks materialise
that matters.

Now if growth had appeared to be stronger than 2.8%, and
inflation becomes excessive, the solution is obvious, well tested and effective
– the Bank of England raises interest rates. But if growth looked like falling well short of 2.8%, the solution – more Quantitative Easing - is untested and very
unclear in its effectiveness. (And before anyone comments, the government knows
it has no intention of telling the Bank to abandon inflation targets.) With
this basic asymmetry, you do not cross your fingers and hope your forecasts are
correct. Instead you bias policy towards trying as far as possible to avoid the
bad outcome. You go for 3.5% or 4% growth, knowing that if this produced
undesirable inflation you could do something about it. That in turn meant not
undertaking the Plan A of severe austerity.

So all the talk about how much austerity, or the
Eurozone, or anything else, caused the current UK recession is beside the point
when it comes to assessing the wisdom of 2010 austerity. Criticising the Bank
of England for underestimating inflation in the past is even more pointless –
do those making the criticism really think interest rates should have been
higher two or three years ago? Even if the Euro crisis has been unforeseeable bad
luck for the government (although I think excessive austerity is having its
predictable effect there to), the government should not have put us in a
position where we seem powerless to do anything about it.

If you are sailing a ship near land, you keep well clear of
the coast, even if it means the journey may take longer. So the fact that the economy has run aground does
not mean the government was just unlucky. You do not embark on austerity when
interest rates are near zero. Keynes taught us that, it is in all the
textbooks, and a government bears responsibility when it ignores this wisdom.
To the extent that the government was encouraged to pursue this course by the Governor
of the Bank of England, that responsibility is shared.

Saturday, 4 August 2012

Watching Mario Draghi trying
to gradually out manoeuvre some of his colleagues in order to rescue the
Eurozone has a certain intellectual fascination, as long as you forget the
stakes involved. I’m not an expert on the rules of this game, so I’m happy to
leave the blow by blow account to others, such as Storbeck,
Fatas,
Varoufakis
and Whelan.

What I cannot help reflecting on is the intellectual
weakness of the position adopted by Draghi’s opponents. These opponents appear obsessed
with a particular form of moral hazard: if the ECB intervenes to reduce the
interest rates paid by certain governments, this will reduce the pressure on
these governments to cut their debt and undertake certain structural reforms. (Alas this concern is often repeated in otherwise more reasonable analysis.) Now
one, quite valid, response is to say that in a crisis you have to put moral
hazard concerns to one side, as every central bank should know when it comes to
a financial crisis. But a difficulty with this line is that it implicitly
concedes a false diagnosis of the major problem faced by the Eurozone.

For most Eurozone countries, the crisis was not caused by
their governments spending in an unsustainable way, but by their private
sectors doing so (for example, Martin Wolf here).
The politics are such that the government ends up picking up the tab for
imprudent lending by banks. If you want to avoid this happening again, you focus
on making sure governments do what they can to prevent excess private sector spending,
which means
countercyclical fiscal policy, and perhaps breaking the political power that
banks have over local politicians.

Trying to do either of these things by forcing excessive
austerity on governments is completely counterproductive. You do not encourage
countercyclical fiscal policy by making it more pro-cyclical. In addition,
creating major recessions in these countries makes it more, not less, likely
that banks will be bailed out. Forcing excessive austerity, as well as doing
nothing to deal with the underlying causes of the crisis, may even have made
the short term problem of default risk worse. Not only have the size of any
bank bailouts increased because of domestic recession, but in the case of
Greece excessive austerity has generated political instability which also increases
default risk.

In a monetary union, a ‘punishment’ for allowing excessive private
sector spending (and therefore the incentive to avoid it) is automatic: the
economy becomes uncompetitive and must deflate relative to its partners to
bring its prices back into line. Adjustment should be painful for creditors and
debtors alike. However there are two clear cut reasons why this deflation should
be gradual rather than sharp. The first
is the Phillips curve: gradual deflation to adjust the price level is much more
efficient than rapid deflation. The second is aversion to nominal wage cuts,
which makes getting significant negative inflation very costly.

It is in this context that the game of chess being played at
the ECB seems so divorced from macroeconomic reality. By delaying intervention,
and insisting on conditionality, the ECB is complicit in creating unnecessarily
severe recessions in many Eurozone countries, and may even be making the
problem of high interest rates on government debt worse. As the interest rate
the ECB sets is close to the zero lower bound, it is almost powerless deal with
the consequences for aggregate Eurozone activity, so the Eurozone as a whole
enters an unnecessary recession. The
OECD is forecasting a -4% output gap for the Euro area in 2013, and only an
inflation nutter would call that as a success for the ECB.

It gets worse. By not using its power (which no one doubts)
to lower interest rates on government debt, it has allowed a crisis of market
confidence to become a distributional struggle
between Eurozone countries. So in effect one set of governments started
financing another, on terms that make it very difficult for debtors to pay, and
so the crisis becomes one that could threaten the cohesion of the Eurozone
itself. The ‘you will have to leave’ threats
to Greece are just a particularly nasty manifestation of this.

There is a line that some people take that the current
crisis shows that a partial economic union, where fiscal policy remains under
the control of nation states, is inevitably flawed, and that the only long term
solution for the Euro area is fiscal as well as monetary union. I think that
case is unproven. If the ECB had undertaken a programme of Quantitative Easing,
directed (as any such programme should be) at markets where high interest rates
were damaging the economy, then economies would have been able to focus on
restoring competitiveness in a controlled and efficient manner. That was never
going to be easy or painless, but it need not have led to the scale of
recession, and the political discord, that we are now seeing.

The current crisis certainly reveals shortcomings
in the original design of the Euro. In my view these shortcomings could have
been (and still could be) solved, if those in charge had looked at what was actually
happening and applied
basic macroeconomic principles and ideas. We have perpetual crisis today
because too many
European policymakers (and, with politicians’ encouragement, perhaps
also voters) are looking at events through a kind of Ordoliberal and
anti-Keynesian prism.
If the current crisis reveals anything, it is how misguided
this ideological perspective is.